IR Lecture 111203 PDF

Lecture on Interest Rates
Josef Teichmann
ETH Zürich
Zürich, December 2011
Josef Teichmann Lecture on Interest Rates

Mathematical Finance
Examples and Remarks
Interest Rate Models
1 / 53
Goals
I Basic concepts of stochastic modeling in interest rate theory,

in particular the notion of numéraire.
I ”No arbitrage” as concept and through examples.
I Several basic implementations related to ”no arbitrage” in R.
I Basic concepts of interest rate theory like yield, forward rate
curve, short rate.
I Some basic trading arguments in interest rate theory.
I Spot measure, forward measures, swap measures and Black’s
formula.
2 / 53
References
As a standard reference on interest rate theory I recommend

[Brigo and Mercurio(2006)].
In german language I recommend
[Albrecher et al.(2009)Albrecher, Binder, and Mayer], which
contains also a very readable introduction to interest rate theory
3 / 53
Modeling of financial markets

We are describing models for financial products related to interest
rates, so called interest rate models. We are facing several
difficulties, some of the specific for interest rates, some of them
true for all models in mathematical finance:
I stochastic nature: traded prices, e.g. prices of interest rate
related products, are not deterministic!
I information is increasing: every day additional information on
markets appears and this stream of information should enter
into our models.
I stylized facts of markets should be reflected in the model:
stylized facts of time series, trading opportunities (portfolio
building), etc.
4 / 53
Mathematical Finance 1
A financial market can be modeled by

I a filtered (discrete) probability space (Ω, F, Q),
I together with price processes, namely K risky assets
(Sn1 , . . . , SnK )0≤n≤N and one risk-less asset S 0 (numéraire),
i.e. Sn0 > 0 almost surely (no default risk for at least one
asset),
I all price processes being adapted to the filtration.
This structure reflects stochasticity of prices and the stream of
incoming information.
5 / 53
A portfolio is a predictable process φ = (φ0n , . . . , φK

n )0≤n≤N , where
i
φn represents the number of risky assets one holds at time n. The
value of the portfolio Vn (φ) is
K
X
Vn (φ) = φin Sni .
i=0
6 / 53
Mathematical Finance 2
Self-financing portfolios φ are characterized through the condition

K
X
Vn+1 (φ) − Vn (φ) = φin+1 (Sn+1
i
− Sni ),
i=0
for 0 ≤ n ≤ N − 1, i.e. changes in value come from changes in

prices, no additional input of capital is required and no
consumption appears.
7 / 53
Self-financing portfolios can be characterized in discounted terms.

fn (φ) = (S 0 )−1 Vn (φ)
V n
fi = (S 0 )−1 S i (φ)
Sn n n
K
X
V
fn (φ) = φin S
fi
n
i=0
for 0 ≤ n ≤ N, and recover
n X
X K
V f0 (φ) + (φ · S)
fn (φ) = V e =V
f0 (φ) + φij (Seji − Sg
i
j−1 )
j=1 i=1
for self-financing predictable trading strategies φ and 0 ≤ n ≤ N.

In words: discounted wealth of a self-financing portfolio is the
cumulative sum of discounted gains and losses. Notice that we
apply a generalized notion of “discounting” here, prices S i divided
by the numéraire S 0 – only these relative prices can be compared.
8 / 53
Fundamental Theorem of Asset Pricing
A minimal condition for modeling financial markets is the

No-arbitrage condition: there are no self-financing trading
strategies φ (arbitrage strategies) with
V0 (φ) = 0, VN (φ) ≥ 0
such that Q(VN (φ) 6= 0) > 0 holds (NFLVR).
9 / 53
In the sequel we generate two sets random numbers (normalized

log-returns) and introduce two examples of markets with constant
bank account and two assets. The first market allows for arbitrage,
then second one not. In both cases we run the same portfolio:
> Delta = 250
> Z = rnorm(Delta, 0, 1/sqrt(Delta))
> Z1 = rnorm(Delta, 0, 1/sqrt(Delta))
10 / 53
Incorrect modelling with arbitrage
> S = 10000
> rho = 0
> sigmaX = 0.25
> sigmaY = 0.1
> X = exp(sigmaX * cumsum(Z))
> Y = exp(sigmaY * cumsum(sqrt(1 - rho^2) * Z + rho * Z1))
> returnsX = c(diff(X, lag = 1, differences = 1), 0)
> returnsY = c(diff(Y, lag = 1, differences = 1), 0)
> returnsP = ((sigmaY * Y)/(sigmaX * X) * returnsX - returnsY) *
+ S
11 / 53
Plot of the two Asset prices

1.3
1.2
X
1.1
1.0
12 / 53
Plot of the value process: an arbitrage

60
cumsum(returnsP)
40
20
0
13 / 53
Correct arbitrage-free modelling
> Delta = 250

> S = 10000
> rho = 0
> sigmaX = 0.25
> sigmaY = 0.1
> time = seq(1/Delta, 1, by = 1/Delta)
> X1 = exp(-sigmaX^2 * 0.5 * time + sigmaX * cumsum(Z))
> Y1 = exp(-sigmaY^2 * 0.5 * time + sigmaY * cumsum(sqrt(1 - rho^2) *
+ Z + rho * Z1))
> returnsX1 = c(diff(X1, lag = 1, differences = 1), 0)
> returnsY1 = c(diff(Y1, lag = 1, differences = 1), 0)
> returnsP1 = ((sigmaY * Y1)/(sigmaX * X1) * returnsX1 - returnsY1) *
+ S
14 / 53
Plot of two asset prices

1.2
1.1
X1
1.0
15 / 53
Plot of the value process: no arbitrage

0
−2
cumsum(returnsP1)
−4
−6
−8
−10
16 / 53
Theorem
Given a financial market, then the following assertions are
equivalent:
1. (NFLVR) holds.
2. There exists an equivalent measure P ∼ Q such that the
discounted price processes are P-martingales, i.e.
1 i 1
EP ( 0
SN |Fn ) = 0 Sni
SN Sn
for 0 ≤ n ≤ N.
Main message: Discounted (relative to the numéraire) prices

behave like martingales with respect to one martingale measure.
17 / 53
What is a martingale?
Formally a martingale is a stochastic process such that today’s best

prediction of a future value of the process is today’s value, i.e.
E [Mn |Fm ] = Mm
for m ≤ n, where E [Mn |Fm ] calculates the best prediction with

knowledge up to time m of the future value Mn .
18 / 53
Random walks and Brownian motions are well-known examples of

martingales. Martingales are particularly suited to describe
(discounted) price movements on financial markets, since the
prediction of future returns is 0. This is not the most general
approach, but already contains the most important features. Two
implementations in R are provided here, which produce the
following graphs.
19 / 53
20 / 53
21 / 53
Pricing rules
(NFLVR) also leads to arbitrage-free pricing rules. Let X be the

payoff of a claim X paying at time N, then an adapted stochastic
process π(X ) is called pricing rule for X if
I πN (X ) = X .
I (S 0 , . . . , S N , π(X )) is free of arbitrage.
This is obviously equivalent to the existence of one equivalent
martingale measure P such that
X πn (X )
EP 0
|Fn =
SN Sn0
holds true for 0 ≤ n ≤ N.

22 / 53
The previous framework for stochastic models of financial markets

is not bound to a ”discrete” setting even though one can perfectly
well motivate the theory there. We shall see two examples and
several remarks in the sequel
I the one-step binomial model.
I the Black-Merton-Scholes model.
I Hedging.
23 / 53
One step binomial model

We model one asset in a zero-interest rate environment just before
the next tick. We assume two states of the world: up, down. The
riskless asset is given by S 0 = 1. The risky asset is modeled by
S01 = S0 , S11 = S0 ∗ u > S0 or S11 = S0 ∗ d
where the events at time one appear with probability q and 1 − q

(”physical measure”). The martingale measure is apparently given
1−d
through u ∗ p + (1 − p)d = 1, i.e. p = u−d .
Pricing a European call option at time one in this setting leads to
fair price
E [(S11 − K )+ ] = p ∗ (S0 u − K )+ + (1 − p) ∗ (S0 d − K )+ .
24 / 53
25 / 53
Black-Merton-Scholes model 1
We model one asset with respect to some numeraire by an
exponential Brownian motion. If the numeraire is a bank account
with constant rate we usually speak of the Black-Merton-Scholes
model, if the numeraire some other traded asset, for instance a
zero-coupon bond, we speak of Black’s model. Let us assume that
S0 = 1, then
σ2t
St1 = S0 exp(σBt − )
2
with respect to the martingale measure P. In the physical measure
Q a drift term can be added in the exponent, i.e.
σ2t
St1 = S0 exp(σBt − + µt).
2
26 / 53
Black-Merton-Scholes model 2
Our theory tells that the price of a European call option on S 1 at

time T is priced via
E [(ST1 − K )+ ] = S0 Φ(d1 ) − K Φ(d2 )
yielding the Black-Scholes formula, where Φ is the cumulative

distribution function of the standard normal distribution and
2
log SK0 ± σ 2T
d1,2 = √ .
σ T
Notice that this price corresponds to the value of a portfolio
mimicking the European option at time T .
27 / 53
Hedging
Having calculated prices of derivatives we can ask if it is possible

to hedge as seller against the risks of the product. By the very
construction of prices we expect that we should be able to build –
at the price of the premium which we receive – a portfolio which
hedges against some (all) risks. In the Black-Scholes model this
hedging is perfect.
28 / 53
A time series of yields
I AAA yield curve of the euro area from ECB webpage.

I Yield curves exist in all major economies and are calculated
from different products like deposit rates, swap rates, zero
coupon bonds, coupon bearing bonds.
I Interest rates express the time value of money quantitatively.
29 / 53
Interest Rate mechanics 1

Prices of zero-coupon bonds (ZCB) with maturity T are denoted
by P(t, T ). Interest rates are governed by a market of (default
free) zero-coupon bonds modeled by stochastic processes
(P(t, T ))0≤t≤T for T ≥ 0. We assume the normalization
P(T , T ) = 1.
I T denotes the maturity of the bond, P(t, T ) its price at a
time t before maturity T .
I The yield
1
Y (t, T ) = − log P(t, T )
T −t
describes the compound interest rate p. a. for maturity T .
I f is called the forward rate curve of the bond market
Z T
P(t, T ) = exp(− f (t, s)ds) 30 / 53
Interest Rate mechanics 2

I The short rate process is given through Rt = f (t, t) for t ≥ 0
defining the “bank account process”
Z t
(B(t))t≥0 := (exp( Rs ds))t≥0 .
0
I No arbitrage is guaranteed if on the filtered probability space

(Ω, F, Q) with filtration (Ft )t≥0 ,
Z T
E (exp(− Rs ds)|Ft ) = P(t, T )
t
holds true for 0 ≤ t ≤ T for some equivalent (martingale)

measure P.
31 / 53
Simple forward rates
Consider a bond market (P(t, T ))t≤T with P(T , T ) = 1 and

P(t, T ) > 0. Let t ≤ T ≤ T ∗ . We define the simple forward rate
through

∗ 1 P(t, T )
F (t; T , T ) := ∗ −1 .
T − T P(t, T ∗ )
and the simple spot rate through
F (t, T ) := F (t; t, T ).
32 / 53
Apparently P(t, T ∗ )F (t; T , T ∗ ) is the fair value at time t of a

contract paying F (T , T ∗ ) at time T ∗ .
Indeed, note that
P(t, T ) − P(t, T ∗ )
P(t, T ∗ )F (t; T , T ∗ ) = ,
T ∗− T
∗ 1 1
F (T , T ) = ∗ −1 .
T − T P(T , T ∗ )
Fair value means that we can build a portfolio at time t and at
P(t,T )−P(t,T ∗ )
price T ∗ −T yielding F (T , T ∗ ) at time T ∗ :
I Holding a ZCB with maturity T at time t has value P(t, T ),
being additionally short in a ZCB with maturity T ∗ amounts
all together to P(t, T ) − P(t, T ∗ ).
I at time T we have to rebalance the portfolio by buying with
the maturing ZCB another bond with maturity T ∗ , precisely
an amount 1/P(T , T ∗ ). 33 / 53
Caps
In the sequel, we fix a number of future dates
T0 < T1 < . . . < Tn
with Ti − Ti−1 ≡ δ.
Fix a rate κ > 0. At time Ti the holder of the cap receives
δ(F (Ti−1 , Ti ) − κ)+ .
Let t ≤ T0 . We write
Cpl(t; Ti−1 , Ti ), i = 1, . . . , n
for the time t price of the ith caplet, and
Xn
Cp(t) = Cpl(t; Ti−1 , Ti )
i=1
for the time t price of the cap. 34 / 53
Floors
At time Ti the holder of the floor receives
δ(κ − F (Ti−1 , Ti ))+ .
Let t ≤ T0 . We write
Fll(t; Ti−1 , Ti ), i = 1, . . . , n
for the time t price of the ith floorlet, and

n
X
Fl(t) = Fll(t; Ti−1 , Ti )
i=1
for the time t price of the floor.

35 / 53
Swaps
Fix a rate K and a nominal N. The cash flow of a payer swap at
Ti is
(F (Ti−1 , Ti ) − K )δN.
The total value Πp (t) of the payer swap at time t ≤ T0 is
Xn
Πp (t) = N P(t, T0 ) − P(t, Tn ) − K δ P(t, Ti ) .
i=1
The value of a receiver swap at t ≤ T0 is
Πr (t) = −Πp (t).
The swap rate Rswap (t) is the fixed rate K which gives
Πp (t) = Πr (t) = 0. Hence
P(t, T0 ) − P(t, Tn )
Rswap (t) = , t ∈ [0, T0 ].
δ n P(t, Ti )
P
36 / 53
Swaptions
A payer (receiver) swaption is an option to enter a payer (receiver)

swap at T0 . The payoff of a payer swaption at T0 is
n
X
Nδ(Rswap (T0 ) − K )+ P(T0 , Ti ),
i=1
and of a receiver swaption

n
X
+
Nδ(K − Rswap (T0 )) P(T0 , Ti ).
i=1
37 / 53
Spot measure
From now on, let P be a martingale measure in the bond market

(P(t, T ))t≤T , i.e. for each T > 0 the discounted bond price
process
P(t, T )
B(t)
is a martingale. This leads to the following fundamental formula of

interest rate theory
Z T
P(t, T ) = E (exp(− Rs ds))|Ft )
t
for 0 ≤ t ≤ T .
38 / 53
Forward measures
∗
For T ∗ > 0 define the T ∗ -forward measure P T such that for any
T > 0 the discounted bond price process
P(t, T )
, t ∈ [0, T ]
P(t, T ∗ )
∗
is a P T -martingale.
39 / 53
Forward measures
For any T < T ∗ the simple forward rate

∗ 1 P(t, T )
F (t; T , T ) = ∗ −1
T − T P(t, T ∗ )
∗
is a PT -martingale.
40 / 53
For any time derivative X ∈ FT ∗ paid at T ∗ we have that the fair

value via “martingale pricing” is given through
∗
P(t, T ∗ )ET [X |Ft ].
The fair price of the ith caplet is therefore given by
Cpl(t; Ti−1 , Ti ) = δP(t, Ti )ETi [(F (Ti−1 , Ti ) − κ)+ |Ft ].
By the martingale property we obtain therefore
ETi [F (Ti−1 , Ti )|Ft ] = F (t; Ti−1 , Ti ),
what was proved by trading arguments before.
41 / 53
Black’s formula
Let X ∼ N(µ, σ 2 ) and K ∈ R. Then we have
log K − (µ + σ 2 )

X + µ+ σ2
2 log K − µ
E[(e − K ) ] = e Φ − − KΦ − ,
σ σ
log K − (µ + σ 2 )

X + log K − µ µ+ σ2
2
E[(K − e ) ] = K Φ −e Φ .
σ σ
42 / 53
Black’s formula for caps and floors
Let t ≤ T0 . From our previous results we know that
Cpl(t; Ti−1 , Ti ) = δP(t, Ti )ET +

t [(F (Ti−1 , Ti ) − κ) ],
i
Fll(t; Ti−1 , Ti ) = δP(t, Ti )ET +

t [(κ − F (Ti−1 , Ti )) ],
i
and that F (t; Ti−1 , Ti ) is an P Ti -martingale.
43 / 53
We assume that under P Ti the forward rate F (t; Ti−1 , Ti ) is an

exponential Brownian motion
F (t; Ti−1 , Ti ) = F (s; Ti−1 , Ti )

1 t
Z Z t
2 Ti
exp − λ(u, Ti−1 ) du + λ(u, Ti−1 )dWu
2 s s
for s ≤ t ≤ Ti−1 , with a function λ(u, Ti−1 ).
44 / 53
We define the volatility σ 2 (t) as

Z Ti−1
2 1
σ (t) := λ(s, Ti−1 )2 ds.
Ti−1 − t t
The P Ti -distribution of log F (Ti−1 , Ti ) conditional on Ft is

N(µ, σ 2 ) with
σ 2 (t)
µ = log F (t; Ti−1 , Ti ) − (Ti−1 − t),
2
σ 2 = σ 2 (t)(Ti−1 − t).
In particular
σ2
µ+ = log F (t; Ti−1 , Ti ),
2
σ 2 (t)
µ + σ 2 = log F (t; Ti−1 , Ti ) + (Ti−1 − t).
2
45 / 53
We have
Cpl(t; Ti−1 , Ti ) = δP(t, Ti )(F (t; Ti−1 , Ti )Φ(d1 (i; t)) − κΦ(d2 (i; t))),
Fll(t; Ti−1 , Ti ) = δP(t, Ti )(κΦ(−d2 (i; t)) − F (t; Ti−1 , Ti )Φ(−d1 (i; t))),
where
F (t;Ti−1 ,Ti )
log κ ± 1 σ(t)2 (Ti−1 − t)
d1,2 (i; t) = p 2 .
σ(t) Ti−1 − t
46 / 53
Concrete calculation of caplet price

Consider the setting t = 0, T0 = 0.25y and T1 = 0.5y . Market
data give us P(0, T1 ) = 0.9753, F (0, T0 , T1 ) = 0.0503 and
λ(u, T0 ) = 0.2 is constant, hence we can calculate
σ(t)2 (T0 − t) = 0.2 ∗ 0.25,
and therefore by Black’s formula gives the caplet price for κ = 0.03
log(0.0503) − log(0.03) + 0.5 ∗ 0.2 ∗ 0.25
0.25 ∗ 0.9753 ∗ (0.0503 ∗ Φ( √ )−
0.2 ∗ 0.25
log(0.0503) − log(0.03) − 0.5 ∗ 0.2 ∗ 0.25
− 0.03 ∗ Φ( √ )),
0.2 ∗ 0.25
where Φ is the cumulative distribution function of a standard
normal random variable, which yields 0.004957.
47 / 53
Exercises
Simulate a simple interest rate model:
I We choose a simple interest rate model of Vasiček type, i.e.
Z t
Rt = exp(−0.2t)0.05 + 0.03 exp(−0.2(t − s))dBs .
0
I First we simulate the bank account, i.e. we calculate the

value B(t) for different trajectories of Brownian motion.
Write an R-function called vasicek with input parameter t and
discretization parameter n which provides the value of B(t).
Use the following iteration for this: B(0) = 1, R(0) = 0.05
and
r
i +1 i i i t t t
B(t ) = B(t ) 1+(R(t )−0.2R(t ) +0.03 N) ,
n n n n n n n
where N is a standard normal random variable. 48 / 53
Bank account in the Vasiček model

> B0 = 1
> X0 = 0.05
> b = 0
> beta = -0.2
> alpha = 0.03
> time = 1
> n = 250
> m = 20
> x <- (1:657)
> y <- sample(x)
> for (j in (1:m)) {
+ B = vector(length = n + 1)
+ X = vector(length = n + 1)
+ X[1] <- X0
+ B[1] <- 1
+ for (i in (1:n)) {
+ W <- rnorm(1)
+ X[i + 1] <- (X[i] + W * (sqrt(time/n)) * alpha * 2) *
+ exp(beta * time/n) + b * time/n
+ B[i + 1] <- B[i] * (1 + X[i + 1] * time/n)
+ }
+ if (j == 1)
+ plot(B, type = "l", ylim = c(0.9, 1.1))
+ else lines(B, col = colors()[y[j]])
+ }
49 / 53
Bank account Scenarios with Vasiček-short-rate

1.10
1.05
1.00
B
0.95
0.90
50 / 53
I Second we take the simulation results and calculate the bond

price (or any other derivative price) by the law of large
numbers
m
1 X
P(0, t) = E (1/B(t)) ∼ 1/B(t)(ωi ).
m
i=1
I Collect the result again in a function called vasicekZCB with

input parameters t, n and m. For large m we should obtain
nice yield curves.
51 / 53
Exam
I No arbitrage theory: discounting, numéraire, martingale

measure for discounted prices, arbitrage.
I Notions of interest rate theory: yield, forward rate, short rate,
simple forward rate, zero coupon bond, cap, floor.
I one calculation with Black’s formula in the forward measure.
52 / 53
[Albrecher et al.(2009)Albrecher, Binder, and Mayer] Hansjörg

Albrecher, Andreas Binder, and Philipp Mayer.
Einführung in die Finanzmathematik.
Mathematik Kompakt. [Compact Mathematics]. Birkhäuser
Verlag, Basel, 2009.
[Brigo and Mercurio(2006)] Damiano Brigo and Fabio Mercurio.

Interest rate models—theory and practice.
Springer Finance. Springer-Verlag, Berlin, second edition, 2006.
With smile, inflation and credit.
53 / 53

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Lecture on Interest Rates

Lecture on Interest Rates

Zürich, December 2011

Josef Teichmann Lecture on Interest Rates

Examples and Remarks

Interest Rate Models

I Basic concepts of stochastic modeling in interest rate theory,

As a standard reference on interest rate theory I recommend

Modeling of financial markets

A financial market can be modeled by

A portfolio is a predictable process φ = (φ0n , . . . , φK

Self-financing portfolios φ are characterized through the condition

for 0 ≤ n ≤ N − 1, i.e. changes in value come from changes in

Self-financing portfolios can be characterized in discounted terms.

for self-financing predictable trading strategies φ and 0 ≤ n ≤ N.

Fundamental Theorem of Asset Pricing

A minimal condition for modeling financial markets is the

such that Q(VN (φ) 6= 0) > 0 holds (NFLVR).

In the sequel we generate two sets random numbers (normalized

Incorrect modelling with arbitrage

Plot of the two Asset prices

Plot of the value process: an arbitrage

Correct arbitrage-free modelling

> Delta = 250

Plot of two asset prices

Plot of the value process: no arbitrage

Main message: Discounted (relative to the numéraire) prices

Formally a martingale is a stochastic process such that today’s best

for m ≤ n, where E [Mn |Fm ] calculates the best prediction with

Random walks and Brownian motions are well-known examples of

(NFLVR) also leads to arbitrage-free pricing rules. Let X be the

holds true for 0 ≤ n ≤ N.

The previous framework for stochastic models of financial markets

One step binomial model

S01 = S0 , S11 = S0 ∗ u > S0 or S11 = S0 ∗ d

where the events at time one appear with probability q and 1 − q

E [(S11 − K )+ ] = p ∗ (S0 u − K )+ + (1 − p) ∗ (S0 d − K )+ .

Our theory tells that the price of a European call option on S 1 at

E [(ST1 − K )+ ] = S0 Φ(d1 ) − K Φ(d2 )

yielding the Black-Scholes formula, where Φ is the cumulative

Having calculated prices of derivatives we can ask if it is possible

A time series of yields

I AAA yield curve of the euro area from ECB webpage.

Interest Rate mechanics 1

Interest Rate mechanics 2

I No arbitrage is guaranteed if on the filtered probability space

holds true for 0 ≤ t ≤ T for some equivalent (martingale)

Simple forward rates

Consider a bond market (P(t, T ))t≤T with P(T , T ) = 1 and

and the simple spot rate through

Apparently P(t, T ∗ )F (t; T , T ∗ ) is the fair value at time t of a

At time Ti the holder of the floor receives

δ(κ − F (Ti−1 , Ti ))+ .

for the time t price of the ith floorlet, and

for the time t price of the floor.

A payer (receiver) swaption is an option to enter a payer (receiver)

and of a receiver swaption

From now on, let P be a martingale measure in the bond market